Why did the talk of the “taper” in the US spook share markets?

The last few weeks seem to have dealt another blow to the idea that stock markets are rational.

The S&P 500 fell almost six per cent between late May and late June, a drop which pretty much everyone has blamed on concerns that the Federal Reserve will reduce, or “taper”, its quantitative easing later this year.
But this doesn’t make much sense. Everybody has known that QE was only temporary and that it would be scaled back as the economy strengthened. So how can the market have fallen so much in response to an event which we should all have seen coming?
There are two, related, answers.

It appears not to matter until it suddenly does
One is that we cannot possibly pay attention to everything. The world economy is just far too complicated for individual minds to comprehend. We therefore focus on a few things to the exclusion of others. Back in April and May, attention was focused upon signs of economic recovery and reduced “tail risk” – the risk of disaster . So markets rose. But attention then shifted to the tapering of QE.
Such shifts are quite common. Sushil Wadhwani, a former member of the Bank of England’s monetary policy committee once said that current account deficits “appear not to matter until they suddenly do”. That’s an example of how attention can change. And one reason why momentum investing is so successful – buying shares with recent good returns – is that when a share rises in price, it attracts the attention of investors to its merits.

As it gets closer, I get scared
Secondly, there is what Thomas Eisenbach of the New York Fed and Martin Schmalz of the University of Michigan call proximity-dependent risk anxiety. We become disproportionately worried by a risk the nearer it becomes. For example, the bride or groom who’s been looking forward to a wedding for months can get cold feet on the day, or the person who happily volunteered for a parachute jump gets second thoughts when the plane door opens. In similar fashion, markets can get the jitters as a widely-anticipated event approaches. Just as we discount the future inconsistently, so too do we discount risks inconsistently.

Investors feel it too
These two phenomena – limited attention and proximity-dependent risk anxiety – help explain that old puzzle, of why stock markets seem so much more volatile than the “fundamentals.” As Stanford University’s Mordecai Kurz has explained, it’s because belief equilibria can suddenly shift. We can move from an equilibrium in which nobody’s much worried about banks’ balance sheets or the ending of QE to one in which everybody is. And when this happens, stock markets will suddenly fall. Share prices will then appear more volatile than they should be.
What matters in investing therefore is not (just) the state of the economy, but rather investors’ attitudes to it. As Maynard Keynes famously said, stock market investing is like one of those now-defunct newspaper competitions in which people have to pick the prettiest faces from a hundred pictures, with the prize going to the person whose choice is closest to the average preferences of all competitors.

Timing is everything?
The trick to timing the stock market is thus to anticipate investors’ preferences. Can this be done? In one sense, no. Experts cannot judge the best times to switch in and out of the market. What’s more their efforts to do so can actually further destabilize the market. If investors think “this asset is overpriced, but it’ll become more overpriced and I can sell before others do” they will buy and so contribute to “rational bubbles”.
In another sense, though, we can sometimes anticipate changes in belief equilibria. One of the strongest rules of investing is “sell in May, and buy on Halloween”. This rule warns us that investors are apt to shift from optimism to pessimism in the summer, and back again in the winter. Beyond this, however, such shifts are generally unpredictable.